If You Want To Get Rich At A Startup, You Better Ask These Questions Before Accepting The Job

Daniel Goodman via Business InsiderThumbs up all around after Yext announced a big $US27 million round of financing. But these employees probably have no idea what that means for their stock options.

When Bryan Goldberg’s first startup, Bleacher Report, sold for more than $US200 million, employees with stock options reacted in one of two ways:

“Some people’s reactions were like, ‘Oh my God, this is more [money] than I ever could have imagined,'” Goldberg previously told Business Insider in an interview about the sale. “Some people were like, ‘That’s it?!’ You never knew what it was going to be.”

If you’re an employee at a startup — not a founder or an investor — and your company gives you stock, you’re probably going to end up with “common stock” or options on common stock. Common stock can make you rich if your company goes public or gets bought at a price per share that is significantly above the strike price of your options. But most employees don’t realise that common stock holders only get paid from the pot of money left over after the preferred stockholders have taken their cut. And in some case common stock holders can find that preferred shareholders have been given such good terms that the common stock nearly worthless, even if the company is sold for more money than investors put into it.

If you ask a few smart questions before accepting an offer, and after each meaningful round of new investment, you don’t have to be surprised by the worth — or lack thereof — of your stock options when a startup exits.

We asked an active New York City venture capitalist, who sits on the board of a number of startups and regularly drafts term sheets, what questions employees should be asking their employers. The investor asked not to be named but was happy to share the inside scoop.

Here’s what smart people ask about their stock options:

1. Ask how much equity you’re being offered on a fully-diluted basis.

“Sometimes companies will just tell you the number of shares [you’re getting], which is totally meaningless because the company could have a billion shares,” the venture capitalist says. “If I just say, ‘You’re going to get 10,000 shares,’ it sounds like a lot, but it may actually be a very small amount.”

Instead, ask what percentage of the company those stock options represent. If you ask about it on a “fully-diluted basis,” this means the employer will have to take into account all stock the company is obligated to issue in the future, not just stock that’s already been handed out. It also takes into account the entire option pool. An option pool is stock that’s set aside to incentivise startup employees.

A simpler way to ask the same question: “What percentage of the company do my shares actually represent?”

2. Ask how long the company’s “option pool” will last and how much more cash the company is likely to raise, so you know whether and when your ownership might get diluted.

Each time a company issues new stock, current shareholders get “diluted,” meaning that the percentage of the company they own decreases. Over many years, with many new financings, an ownership percentage that started out big can get diluted down to a small percentage stake (even though its value may have increased). If the company you’re joining is likely to need to raise a lot more cash over the next several years, therefore, you should assume that your stake will be diluted considerably.

Some companies also increase their option pools on a year-by-year basis, which also dilutes existing shareholders. Others set aside a large enough pool to last a couple of years. Option pools can be created before or after an investment gets pumped into the company. Fred Wilson of Union Square Ventures likes to ask for pre-money (pre-investment) option pools that are big enough to “fund the hiring and retention needs of the company until the next financing.”

The investor we talked to explained how option pools are often created by investors and entrepreneurs together: “The idea is, if I’m going to invest in your company, then we both agree: ‘If we’re going to get from here to there, we’re going to have to hire this many people. So let’s create an equity budget. I think I’m going to have to give away probably 10, 15 per cent of the company [to get there].’ That’s the option pool.”

3. Next, you should find out how much money the company has raised and on what terms.

When a company raises millions of dollars, it sounds really cool. But this isn’t free money, and it often comes with conditions that can affect your stock options.

“If I’m an employee joining a company, what I want to hear is you haven’t raised a lot of money and it’s ‘straight preferred [stock],'” the investor says.

The most common kind of investment comes in the form of preferred stock, which is good for both employees and entrepreneurs. But there are different flavours of preferred stock. And the ultimate value of your stock options will depend on which kind your company has issued.

Here are the most common kinds of preferred stock.

Straight preferred – In an exit, preferred stock holders get paid before common shareholders (employees) get a dime. The cash for the preferred goes directly into the VC’s pocket. The investor gives us an example: “If I invest $US7 million in your company, and you sell for $US10 million, the first $US7 million to come out goes to preferred and the remainder goes to common stock. If the startup sells for anything over the conversion price (generally the post-money valuation of the round) that means a straight preferred shareholder will get whatever percentage of the company they own.”

Participating preferred – Participating preferred comes with a set of terms that increase the amount of money preferred holders will get for each share in a liquidation event. Participating preferred stock places a dividend on preferred stock, which trumps common stock when a startup exits. Investors with participating preferred get their money back during a liquidation event (just like preferred stock holders), plus a predetermined dividend.

Participating preferred stock is usually offered when an investor does not believe the company is worth as much as the founders believe it is — so they agree to invest in order to challenge the company to grow big enough to justify and eclipse the conditions of the participating preferred stock holders.

The bottom line with participating preferred is that, once the preferred holders have been paid, there will be less of the purchase price left over for the common shareholders (e.g., you).

Multiple liquidation preference — This is another type of term that can help preferred holders and screw common stockholders. Unlike straight preferred stock, which pays the same price per share as common stock in a transaction above the price at which the preferred was issued, a multiple liquidation preference guarantees that preferred holders will get a return on their investment.

To use the initial example, instead of an investor’s $US7 million invested coming back to them in the event of a sale, a 3X liquidation preference would promise the preferred holders the first $US21 million of a sale. If the company sold for $US25 million, in other words, the preferred holders would get $US21 million, and the common shareholders would have to split $US4 million. A multiple liquidation preference isn’t very common, unless a startup has struggled and investors demand a bigger premium for the risk they’re taking.

Our investor estimates that 70% of all venture-backed startups have straight preferred stock, while about 30% have some structure on the preferred stock. Hedge funds, this person says, often like to offer big valuations for participating preferred stock. Unless they’re exceptionally confident in their businesses, entrepreneurs should beware of promises such as, “I just want participating preferred and it will disappear at 3x liquidation, but I’ll invest at a billion-dollar valuation.” In this scenario, the investors obviously believe the company won’t reach that valuation — in which case they get 3X their money back, and may wipe out the holders of common stock.

4. How much, if any, debt has the company raised?

Debt can come in the form of venture debt or a convertible note. It’s important for employees to know how much debt there is in the company, because this will need to be paid off to investors before an employee sees a penny from an exit.

Both debt and a convertible note are common in companies that are doing extremely well, or are extremely troubled. Both allow entrepreneurs to put off pricing their company until their companies have higher valuations. Here are the common occurrences and definitions:

Debt — This is a loan from investors and the company has to pay it back. “Sometimes companies raise a small amount of venture debt, which can be used for a lot of purposes, but the most common purpose is to extend their runway so they can get a higher valuation in the next round,” the investor says.

Convertible note — This is debt that is designed to convert into equity at a later date and higher share price. If a startup has raised both debt and a convertible note, there may need to be a discussion among investors and founders to determine which gets paid off first in the event of an exit.

5. If the company has raised a bunch of debt, you should ask how the payout terms work in the event of a sale.

If you’re at a company that has raised a lot of money, and you know the terms are something other than straight preferred stock, you should ask this question.

You should ask at exactly what sale price (or valuation) your stock options start being “in the money,” keeping in mind that debt, convertible notes, and structure on top of preferred stock will affect this price.

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